By Sandy Soltis, tax partner, Blackman Kallick Bartelstein, LLP
Updated September 2009
U.S. tax laws are complex. Because of that complexity, tax practitioners need to be knowledgeable about both the tax laws and what their clients are doing. This is even more important when your client is doing business overseas. Not only does the tax practitioner need to understand U.S. tax laws, he or she also needs to know how to advise the client on the tax considerations of its overseas operations, both in the U.S. and the foreign country. International tax is not an area for dabblers. Tax practitioners can be sued for failing to advise about international tax issues, tax filing requirements of foreign countries, or reporting foreign income on U.S. tax returns. Some allegations of omission can be as simple as failure to advise clients about water's edge elections available in some states.
Some of the major considerations include:
Transfer Pricing
When a U.S. company buys or sets up an entity in a foreign country, there are generally several types of transactions that occur between the entities. These include purchasing or selling a tangible product, providing intangible assets to the foreign entity for use in its operations, and assistance from the head office in the U.S. for administrative functions, among others.
The price paid, or "transfer price," for each of these activities may be challenged by the U.S. The transfer price must be at arm's length to be accepted for U.S. tax purposes. In general, an arm's length price is the amount that would be charged to an unrelated party for the same or similar transactions under similar circumstances.
There has been an increase in transfer pricing regulations and enforcement. Tax authorities generally require a transfer pricing study to support cross border transactions and agreements between entities within a global organization. Significant penalties can apply if the taxpayer cannot support the transfer price charged to a related party. To avoid the imposition of a penalty, a U.S. taxpayer must maintain contemporaneous documentation to establish the transfer price, and must produce such documentation to the IRS within 30 days of its request during an audit.
Failure to comply with the documentation requirement can result in a penalty on any tax underpayment due to IRS adjustments. The penalty is 20% or 40% of the tax underpayment, depending upon the amount of the adjustment.
In addition to U.S. transfer pricing rules, many developed foreign countries have had transfer-pricing rules in place for many years. On January 1, 2008, China's New and Unified Enterprise Income Tax Law became effective. This new law includes documentation requirements and transfer pricing penalties.
It is important at the outset of discussions to advise clients in writing regarding both the transfer pricing rules and the related documentation requirements. Liability insurance providers found that many tax claims revolve around the alleged failure of the tax adviser to timely advise a client regarding applicable tax regulations and rules when they first began discussing a planned or proposed transaction.
Structuring Foreign Operations of U.S. Companies
One of the most important considerations for a U.S. company setting up a foreign operation is the structure of the entities. There may be different tax consequences in the U.S. or the foreign country for an operation set up as a corporation in the foreign country versus a branch operation or joint venture. Whether the foreign operation is funded with equity or debt can also have tax consequences. In some countries, the deduction of interest expense may be limited if the equity is not sufficient under the foreign country rules. Certain types of entities may qualify for treaty benefits, while others may not qualify. As with transfer pricing rules, it's important to document all discussions with the clients on international tax issues (e.g., controlled foreign corporations), analysis of the tax implications of each structure, including benefits and risks, authoritative support for same, and exit strategies if the tax law changes.
One of the main goals of the structure is to minimize overall global tax. The type of entity chosen and the country the taxpayer chooses for its foreign operations can assist in reducing the overall tax. It is recommended that an experienced tax advisor in the foreign country participate in the planning process to insure that foreign country requirements are understood.
Once a structure is in place, it can be costly to unwind. It is important for both the client and the tax advisor to understand the pros and cons of the contemplated structure so there are no surprises. Once a structure is selected, there should be correspondence to and from the client confirming that the client has evaluated the recommended structure and agreed to it. This serves as critical evidence that the client considered the related risks prior to acting on recommendations.
Tax Treaties and Withholding
At some point, it is likely that the parent company will want to repatriate some of the profits of the foreign entity back to the U.S. In many cases, the payor country will be required to withhold tax from the distribution. An income tax treaty between the foreign country and the U.S. may have a reduced rate of withholding tax on dividend distributions between treaty countries.
Filing Requirements for Taxpayers with Foreign entities or Foreign accounts
The U.S. has many disclosure filing requirements for foreign operations of U.S. entities. Failure to file these forms can results in minimum penalties of $10,000 and the penalties can go higher depending upon the facts. Below is a non-inclusive list of some of the disclosure forms required to be filed.
Form TD F 90-221
Report of Foreign Bank and Financial Accounts (FBAR). This form reports direct or indirect financial interest in or signature authority over a financial account located in a foreign country. This is an annual report due June 30 for U.S. citizens, residents and certain other persons. Firms may have recently learned that their clients have an FBAR filing obligation but did not have sufficient time to gather the information necessary to file the FBAR by the June 30, 2009 due date. If the client paid tax on all their taxable income for prior years but did not file FBARs, the firm should advise the client to file the delinquent FBAR report by the extended due dates based on their facts and circumstances. A statement should be attached that explains why the report is being filed late.
Form 5471
Information Return for certain Foreign Corporations of U.S. persons. Generally, officers, directors or shareholders in certain foreign corporations are required to report information on this form. This form is filed annually with the U.S. person's tax return. A separate penalty may apply to each Form 5471 filed after the income tax return due date, regardless of the fact that no tax is due with the return. IRC Section 6038(b)(1) provides a monetary penalty of $10,000 for each Form 5471 that is filed after the income tax return due date (including extensions) or does not include complete and accurate information as described in Section 6038(a).
Form 5472
Information return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. This form is filed annually with the U.S. tax return.
Form 8865
Return of U.S. Persons With Respect to Certain Foreign Partnerships. This form is filed annually to report interest in and transactions with foreign partnerships, transfers of property to the foreign partnership, and acquisitions, dispositions and changes in foreign partnership interests.
Form 926
Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property (including cash) to foreign corporation and certain other information. If the transferor is a partnership, the domestic partners of the partnership, not the partnership itself, are required to file Form 926. The penalty for failure to file this form for each transfer is ten percent of the value of the property transferred up to a maximum of $100,000 per return. There is no limit on the penalty if the failure to report the transfer was intentional.
As evidenced by this information, any taxpayer with foreign operations and their tax advisor need to be aware of U.S. filing requirements.
The IRS currently has a voluntary disclosure program in place for taxpayers with unreported offshore activities. The objective of this program is to bring taxpayers that have undisclosed foreign accounts or entitles into compliance with the U.S. tax laws. The IRS is offering a uniform penalty structure for taxpayers that voluntarily come forward. More information can be found on the IRS website at IRS.gov. Tax practitioners need to remain vigilant when entering into discussions with clients regarding unreported foreign income. Clients may be subject to criminal prosecution, and the confidentiality privilege that exists between a tax practitioner and their client is limited in a number of respects. If the client discloses information that you believe could result in criminal prosecution for violation of tax laws, it is important to immediately terminate the discussion and inform the client of the need to retain an attorney to represent them in the matter. Advise the client that the attorney can in turn retain you to provide advice or prepare tax returns, and that this arrangement is necessary to provide them with appropriate protection under the circumstances.
Conclusion
U.S. tax laws are complex. This is particularly true with respect to taxpayers with foreign operations. There are laws that need to be understood, treaties that can change the results, and clients rely on their tax advisors for the answers they need. Additionally, it is critical from the perspective of both your firm and the client that your recommendations and the client's decisions regarding foreign tax matters be carefully documented in your working paper file and in correspondence with the client.
U.S. tax consequences of international transactions can be very different from similar domestic transactions. It is important to understand both the U.S. and foreign tax consequences of a transaction. If your firm does not have international tax planning expertise, consult with a firm that does. Many accounting and legal firms belong to a network of firms in various foreign countries, which can give you access to experienced professionals in a specific country.
This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
